This blog aims to study the mechanics of business and occasionally find a gem of insight.

(Consult your financial adviser before making investment decisions. Following the advice here does not guarantee performance and there is a substantial risk of loss)

Sunday, January 18, 2009

Sunday Reflection: Behaviour of "The Market"

There are many fundamental or technical analysis techniques for stocks and investors have different models for understanding pricing behaviour.

But one interesting characteristic I've noticed is that in bullish times, stock behaviour can seem to defy gravity and analysts are carried along for the ride. Suddenly PE ratios soar into seemingly unreasonable numbers like 30 or 40. Conversely in bearish markets, if investors become nervous and start dumping stock, prices can go into free fall (PE of 2 or 3 for strong companies?).

What exactly is a PE ratio? Well it's literally the price divided by the earnings. But what does it mean? Well consider if you bought any sort of income earning investment. Let's say a house. Let's say you bought it at $150k. Let's also say that you can rent it out for $15k per year. That's a PE ratio of 10 (Price / Earnings = $150k / $15k). Anyone with basic math skills can tell you that you will pay off the house in 10 years (for simplicity this example excludes TVM, mortgage interest, taxes etc). Imagine if you could own something that would pay for itself such a short (speaking in terms of investment horizons) time span as 2 or 3 years! It's like buying the same $150k house and being paid $50k to $75k in rent per year!

Or for a high PE ratio: Imagine having an asset that would pay for itself after 40 years! Most of us would probably be dead by then (or basically, you'll never see your money again).

Consider also a loan. Imagine that you gave someone $100 and had annual interest of $5 (5%). If you were to use a "PE" calculation, you would get 20 (you paid $100 and receive "earnings" of $5). So this way you can see that PE's can be converted into yields (inverse relationships).

They only way to justify these extreme ratios is if there is something going on with the growth (hence many fund managers use PEG - Price to earnings growth where PEG is usually equal to PE / Growth rate and is normally equal to 1, usually regardless of asset class).

In other words? The only reason why companies should have such extreme PE ratios is if they are about to close shop / declare chapter 11 or they are experiencing explosive growth. Otherwise, they should act as red lights that a major change in the market is about to occur.

There is a big difference between trading within a reasonable spread and extreme over(under) subscribing.

I think what many people forget is that the stock market is a market like any other and that the securities products (like any other products) are limited in nature. Because securities aren't physically manifested, many investors forget that there isn't an infinite amount of stock in the market place and at the extreme bearish or bullish markets securities behave as any microeconomic supply and demand curve would anticipate. Just as companies can struggle to find capital, savers can also struggle to find good places to put their capital.

Often, the intrinsic value of investment grade products change and with large swings disproportionate to their actual value. However at that point, what you have to realize is that you are not longer just making money off of the success of the company, but also the foolishness of greedy investors. When you sell at a high price, part of what is built into that price besides the actual success of the company are the expectations of overzealous buyers. And visa versa.

There is only a certain amount of value that is retained (or lost) in a company in good or bad times and a smart investor understands when they are only making money "on paper". Holding on at that point becomes a gamble that has less to do with quantitative analysis of stocks than it does on human behaviour.

I think the most reasonable solution is for smart people to make money at either end of the spectrum and follow the old adage: Buy low sell high and to intercept stocks at extreme prices. The problem is that people become emotionally involved with their stock. The trick is not only to do fundamental analysis, but also understand human behaviour when it comes to stock highs and lows.

"You can make your twenty percent at the start or at the end,but I prefer to make my 60% in the middle."